Sunk Cost Trap: What it is, How it Works, How to Avoid it

The topic that once interested you no longer does, and it’s a struggle to get yourself to sit down at your desk and start typing. But you’re two hundred pages in and have dedicated hundreds of hours to researching and writing your novel. Keep in mind, other fees such as trading (non-commission) fees, Gold subscription fees, wire transfer fees, and paper statement fees may apply to your brokerage account. Let’s say you’ve been driving an old used car for the past few years. Lately, the car has needed expensive repairs totaling several thousand dollars.

Sunk costs should not be considered when making the decision to continue investing in an ongoing project, since these costs cannot be recovered. However, many managers continue investing in projects because of the sheer size of the amounts already invested in prior periods. They do not want to “lose the investment” by curtailing a project that is proving to not be profitable, so they continue pouring more cash into it. Rationally, they should consider earlier investments to be sunk costs, and therefore exclude them from consideration when deciding whether to continue with further investments. Rego, Arantes, and Magalhães point out that the sunk cost effect exists in committed relationships. Therefore, It should not be a factor in current decision-making.

At some point, the rent may become an expense you can’t recover through your shop’s profit (a sunk cost). But after spending so much money on repairs, you decide you’d rather fix the old costing methods and important costing terms car so that the money you spent previously wasn’t all for nothing. You believe that you “invested” a lot of money into the car, and you don’t want to “lose” it by getting a new one.

After the renovation, you are assessing your costs and earnings and wondering if you can stay afloat financially. The sunk cost fallacy is a cognitive bias that makes you feel as if you should continue pouring money, time, or effort into a situation since you’ve already “sunk” so much into it already. This perceived sunk cost makes it difficult to walk away from the situation since you don’t want to see your resources wasted. But what about those organizations that know they are heading down the path to failure, but are reluctant to turn back due to the time and effort they’ve put in and an inability to recognise their shortcomings? In this feature, Sam Dunscombe, Head of Growth at digital BSS provider Mobilise, explores the sunk cost fallacy in relation to digital transformation. Most established businesses have a solid IT infrastructure in place.

What is the sunk cost fallacy?

It is irrational to use irrecoverable costs to justify a present decision. If we acted rationally, only future costs and benefits would be taken into account. Regardless of what we have already invested, we will not get it back whether or not we follow through on the decision. In accounting, finance, and economics, all sunk costs are fixed costs. The defining characteristic of sunk costs is that they cannot be recovered.

  • After a test run, the customer feedback is that the new product is not something you should sell.
  • The sunk cost trap explains why people finish movies they are not enjoying, finish meals that taste bad, keep clothes in their closet that they’ve never worn and hold on to investments that are underperforming.
  • Customers must read and understand the Characteristics and Risks of Standardized Options before engaging in any options trading strategies.

A sunk cost refers to money that has already been spent and cannot be recovered. A manufacturing firm, for example, may have a number of sunk costs, such as the cost of machinery, equipment, and the lease expense on the factory. Sunk costs are excluded from a sell-or-process-further decision, which is a concept that applies to products that can be sold as they are or can be processed further. Overcoming the sunk cost dilemma involves recognizing sunk costs, reframing your perspective, evaluating the current situation, and considering opportunity cost. You must usually be deliberate when considering sunk costs and be mindful of how they may (or more importantly not) have implications on future decisions.

An example of a sunk cost would be spending $5 million on building a factory that is projected to cost $10 million. The $5 million already spent—the sunk cost—should not be taken into account when deciding whether the factory should be completed. What ought to matter instead are expectations of future costs and future returns once the factory is operational. A sunk cost is a cost that has already occurred and cannot be recovered by any means.

sunk cost

The sunk cost fallacy can affect our decisions in response to other people’s past investments. The sunk cost fallacy occurs because we are not always rational decision-makers. On the contrary, we are often influenced by our emotions, which tie us to our prior commitments even in the face of evidence that this is not in our best interests. Instead of considering the present and future costs and benefits, we remain fixated on our past investments and let them guide our decisions. The sunk cost fallacy occurs when we feel that we have invested too much to quit.

Either way, the $20 you spent on the first book becomes a sunk cost — You can’t recover that expense regardless of whether you finish the book. You decide to purchase new office equipment for your business, including desks, computers, and chairs. The company you purchase the equipment from has a 90-day return policy.

For product managers, sunk cost fallacy can cloud rational thinking. Evangelizing a new feature or product and motivating others around them are central to the PM role. Unsurprisingly, recognizing that a feature or product is no longer achieving its objectives after investing considerable time, energy, and resources can be challenging. It pays $5,000 a month for its factory lease, and the machinery has been purchased outright for $25,000. The company produces a basic model of a glove that costs $50 and sells for $70.

Why is the sunk cost fallacy a problem?

If you resell the equipment for a lower cost than the purchase price, the difference between the original cost and the resell cost is the sunk cost. The sunk cost fallacy is closely related to the bias of loss aversion, which describes how the pain of losing is psychologically more powerful than the pleasure of gaining. Read this TDL article to learn how this bias makes us buy insurance, avoid worthwhile financial risks, and how overcoming it can lead to highly advantageous decisions.

Opportunity Cost

They recognized that the opportunity cost of abandoning the project was substantial in terms of international prestige and the cultural and economic benefits the completed Opera House would bring to Sydney. They also recognized the need to find additional funding sources and raised money via lottery systems. When considering opportunity costs, it is critical to disregard sunk costs. That is because these costs have already been incurred; because there is no ability to recover these funds, the sunk cost should have no financial bearing on future decisions.

You’re a homebuilder during the bubble and you’ve started work on 20 spec homes in a small development. You’ve cleared the land, prepped the home sites and brought in power, water and sewer. Halfway through construction of the homes, the real estate market starts to crash.

How to avoid it

Have you ever realized 30 minutes into watching a movie that you don’t enjoy it but continue to watch it anyway? We continue wasting our time on a boring movie since we have already invested 30 minutes of our time into it. This study suggested that the more money we initially invest in education, the more likely we are to continue with it because of the sunk cost fallacy.

The sunk cost dilemma is also commonly discussed when considering investments, primarily in volatile investments like equity markets. Investors that have limited capital must make decisions on whether to hold or sell securities and must make the decision independent of historical emotions. Yes, the sunk cost dilemma is prevalent in business contexts where investments have been made in projects, products, or ventures that are not performing as expected. Companies must often pivot projects, make capital allocation decisions, and make tough decisions on when to forgo continuing a project.

In business, the axiom that one has to “spend money to make money” is reflected in the phenomenon of the sunk cost. A sunk cost differs from future costs that a business may face, such as decisions about inventory purchase costs or product pricing. Sunk costs are excluded from future business decisions because they will remain the same regardless of the outcome of a decision. A sunk cost is a cost that an entity has incurred, and which it can no longer recover.

Understanding the underlying psychology of the sunk cost mindset can shed light on why it’s so difficult to let go. In December, its value has dropped to $100 even though the overall market and similar stocks have risen in value over the year. Instead of selling the stock and putting that $100 into a different stock that is likely to rise in value, she holds on to Company X’s stock, which in the coming months becomes worthless. While closing the chapter on the situation—despite how much you’ve spent—may conjure feelings of fear or nervousness, doing so actually opens you up to new situations that will serve you better. The opportunity cost of manufacturing Product A is the profit you could make from Product B. The opportunity cost of manufacturing Product B is the profit you could make from Product A.